Why Commodities and International Investing Are Key Success Factors for a Diversified Portfolio

Commodity and international investments have a reputation for being risky. But once you get to know them, you might consider inviting them into your portfolio.

Roger Gibson, best-selling author of Asset Allocation: Balancing Financial Risk, joined us a few weeks ago to discuss portfolio construction and the benefits of diversification. A replay of the webcast is available for a limited time here.

Which asset class would you expect to have generated the best performance over the past four decades or so – domestic stocks, commodity-linked securities or a portfolio split evenly between the two?

Here is Roger’s chart showing a hypothetical investment of $1. He uses the S&P 500 Index for U.S. stocks and the S&P GSCI Commodity Index for commodities. For the combined portfolio, he assumes annual rebalancing to maintain the 50-50 allocation.

His math shows that an investment of $1 in the S&P 500 in 1971 would have grown to $36.26 by the end of 2009, and an identical investment in the S&P GSCI would have increased to $32.07.

But look what happens when you split that dollar between the two starting in 1971. By the end of 2009, that original dollar would be supersized to nearly $52.

As Roger put it in the webcast, “The whole outperformed the components. And it did so as a result of the reduction in volatility relative to the components. That is also an outcome that you did not ever have to predict what was going to happen in the short run. All you had to do is have balanced representation and keep rebalancing and keep holding.”

Even if it has the potential for lofty returns, portfolios also can’t be built on a mountain of risk. Optimal performance achieves the highest return with the lowest amount of risk.

To illustrate the importance of portfolio diversification, Roger set up an assortment of portfolios formed from different combinations of four asset classes:

Roger then back-tested these portfolios over the past 37 years, to gauge how each performed. You can see how each combination of asset classes fared from the chart. The y-axis measures each portfolio’s return while the x-axis measures its volatility, represented by its standard deviation. An ideal portfolio would show up in the upper left-hand corner of the chart—the highest returns with the lowest volatility.

This illustration shows just how powerful commodities are for a portfolio. In the upper left-hand corner (circled in red), you’ll see that the best-performing portfolios all have an allocation to commodities (Asset Class D). Adding a dash of international securities to the mix (Asset Class B) can increase the return but it also comes with an additional amount of volatility.

The chart also illustrates the long-term benefits of diversifying into multiple asset classes and rebalancing on a regular basis. You can see that a combination of all four asset classes outpaced the individual performance of any one asset class and with less volatility.

This webcast is only available for a limited time so I encourage you to listen to the replay soon. This week I spoke week with CNBC’s host Larry Kudlow about gold. If you haven’t already had a chance to watch the interview, you can do so here.

Diversification does not protect an investor from market risks and does not assure a profit. Standard deviation is a measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is also known as historical volatility. The S&P 500 Stock Index is a widely recognized capitalization-weighted index of 500 common stock prices in U.S. companies. The S&P GSCI Spot index tracks the price of the nearby futures contracts for a basket of commodities. The MSCI EAFE (Europe, Australia and Far East) Index measures the performance of the leading stocks in 21 developed countries outside North America. The FTSE NAREIT Equity REITS Index is a broad-based index consisting of real estate investment trusts (REITs). Investing in real estate securities involves risks including the potential loss of principal resulting from changes in property value, interest rates, taxes and changes in regulatory requirements.

Frank Holmes is CEO and chief investment officer of U.S. Global Investors, Inc., which manages a diversified family of mutual funds and hedge funds specializing in natural resources, emerging markets and infrastructure.

The company’s funds have earned more than two dozen Lipper Fund Awards and certificates since 2000. The Global Resources Fund (PSPFX) was Lipper’s top-performing global natural resources fund in 2010. In 2009, the World Precious Minerals Fund (UNWPX) was Lipper’s top-performing gold fund, the second time in four years for that achievement. In addition, both funds received 2007 and 2008 Lipper Fund Awards as the best overall funds in their respective categories.

Mr. Holmes was 2006 mining fund manager of the year for Mining Journal, a leading publication for the global resources industry, and he is co-author of “The Goldwatcher: Demystifying Gold Investing.”

He is also an advisor to the International Crisis Group, which works to resolve global conflict, and the William J. Clinton Foundation on sustainable development in nations with resource-based economies.

Mr. Holmes is a much-sought-after conference speaker and a regular commentator on financial television. He has been profiled by Fortune, Barron’s, The Financial Times and other publications.